Productivity: Still Getting Stronger

Tech-driven productivity is powering profits, stock prices-and now, spending

It has been a long time since prospects for the U.S. economy looked this good. Profits are up, capital spending is rising, and inflation remains under control. Even ailing manufacturers are showing signs of life, with the Institute for Supply Management reporting on Sept. 2 an upswing in factory orders and production. And following the second quarter's surprisingly strong 3.1% gain in gross domestic product, economists are scrambling to revise their second-half forecast skyward. Many now think growth could finish the year at a healthy 4% clip.

But the most important news is the continuing surge in productivity. The latest numbers from the Bureau of Labor Statistics, released on Sept. 4, are expected to show productivity growth for first-half 2003 at above 4%, exceeding expectations. Each additional quarter that it stays high helps convince economists and business executives that an era of strong productivity growth is here to stay. Indeed, some economists think the U.S. can again sustain productivity growth as high or higher than the nearly 3% average of the economic Golden Age, from 1948 to 1973. "The U.S. economy is in the midst of an historic productivity boom," says John Lipsky, chief economist at J.P. Morgan Securities Inc.

That's of more than just academic interest. The continued surge in productivity is a key reason why profits have strengthened considerably in recent quarters even as growth remained tepid. Even now, pricing power remains nonexistent in many sectors, and capacity is excessive. Yet ever-improving productivity has enabled companies to squeeze costs and rebuild their bottom lines.

All that is combining to provide a powerful payoff. As tax cuts and monetary stimulus start to work their magic on the economy and give a boost to demand, investors and executives across Corporate America are finally starting to crawl out of the psychological bunker many have holed up in for the last two years. With profits strong and growth beckoning, stocks are up, and newly optimistic execs are loosening purse strings to spend on technology again.

None of that would be happening without the amazing resilience of U.S. productivity. What makes it most surprising is that many economists had predicted the opposite: Its growth was supposed to slow after the Roaring Nineties. The downturn itself was expected to dampen productivity after 2001. And security spending after September 11 was expected to divert resources into essential but nonproductive uses. Plus, the drop in business investment in the last couple of years was supposed to dent productivity.

So why has it exceeded even optimistic expectations? For one thing, information technology has proven even more potent than economists believed. Many companies are only now making full use of computers and software bought during the tech-spending boom that ended in 2000. "It takes one, two, three years to get down the learning curve and figure out new ways to use it," says General Electric Co. Chairman and CEO Jeffrey R. Immelt. Others, such as Cisco Systems (CSCO ) Inc. Chief Executive John Chambers, put the learning curve at five to seven years -- meaning the U.S. could benefit for years to come.

General Motors (GM ) Corp. was long ridiculed for blowing cash on ineffective factory automation. GM is finally getting the hang of technology. Heavy investment to modernize its 17 North American stamping plants raised stamped pieces per labor hour 13% in 2002 alone, estimates manufacturing consultant Harbour & Associates Inc. GM has also cut its North American engineering costs 44% while working on a third more products. The savings, GM claims, are in the billions of dollars.

Many companies have also gotten smarter about how they spend on tech. Merrill Lynch (MER ) & Co.'s Merrill Online trading platform was at first seen as a threat by its thundering herd of financial advisers, and many customers preferred to consult their advisers instead of investing on their own online. Now, Merrill is trying again, investing $1 billion in cooperation with Thomson Financial on "wealth management workstations" intended to strengthen the bond between advisers and clients. "We will save tens of millions of dollars annually," says Byron Vielehr, chief technology officer of Merrill's global private client group.

The need to collaborate on big, industrywide projects -- which can often take time to unfold -- also explains why more gains are flowing in now. Procter & Gamble (PG ) Co. Chief Information Officer Stephen N. David expects that a new, industrywide data-sharing project called UCCnet Inc. will enable P&G to save an immediate $40 million a year or more. Five years in the making, UCCnet will cut the volume of products P&G ships to stores and then gets back unsold. And as the entire industry embraces UCCnet, David expects even bigger gains.

Yet technology explains only part of the productivity boom. Economists also failed to appreciate how tighter management could contribute to efficiency gains year after year. Practices such as benchmarking performance against comparable companies, outsourcing, use of temporary workers, and business-process redesign have not only raised the level of productivity but raised the rate at which companies improve. Companies are also quicker to resort to layoffs. Painful though that might be, it helps avoid the big drops in productivity that come from having far too big a workforce when orders dry up.

How high can productivity growth go? From 1948 to 1973, it averaged a little less than 3% a year. Then it slumped to under 1.5% annually from 1973 to 1995. Productivity rebounded to 2.5% in the next five years and has soared to 3.9% annually since. So long-run estimates are being ratcheted up. While few think the first-half rate of 4% is sustainable, the Federal Reserve Board is implicitly predicting long-run productivity growth of 2.5% to 3%. J.P. Morgan senior economist James Glassman estimates it at about 3%.

That means that over the longer term, the economy is capable of higher growth without inflation than many economists have predicted. If long-term productivity is now closer to 3% and the labor force is growing at 1% a year, output can grow steadily at roughly 4%.

There is a downside, of course. While it's good for the economy as a whole, rising productivity accounts for the jobless recovery the U.S. has seen so far -- and will continue to see for some time. Since rising productivity lets companies meet new demand without adding workers, GDP will have to grow at a higher rate than in the past before new jobs are created. Most economists think it will take a long period of growth above 4% for the unemployment rate, now over 6%, to fall back to 5% or so.

And some economists continue to fear that the latest signs of a productivity-led economic recovery could be another false dawn. Columbia University economist Edmund S. Phelps worries that in their cost-cutting zeal, companies may have carved too deeply into research and development.

He may be right. But many companies with a reputation for ruthless cost-cutting, such as Wal-Mart Stores (WMT ) Inc., continue to invest for the future. Says Wal-Mart Chief Information Officer Linda Dillman: "There are a lot of CIOs right now who are trying to defend their existence.... That's not a question I ever get. It's more a battle over what are the long list of things we think we can go make a difference with."

American business is getting its animal spirits back. And the productivity surprise has a lot to do with it.

By Peter Coy in New York, with Timothy J. Mullaney in New York, and bureau reports

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